Question: Are Pennsylvania personal injury settlements and awards taxable?
Answer: It depends.
Pennsylvania personal injury settlements and awards that reimburse for lost wages are absolutely taxable.
The question of taxability gets trickier when the money was obtained for non-economic damages like pain and suffering, emotional distress, embarrassment and humiliation.
The Federal tax code, specifically I.R.C. § 61(a) states, taxpayers are liable for all gross income, which is defined as “all income from whatever source derived.” 26 U.S.C. § 61(a).
So first, what is income?
In the seminal tax case of Glenshaw Glass, the court defines “income” for tax purposes as “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” 348 U.S. 426, 431 (1955). There exists a litany of cases wherein the SC has instructed that § 61 should be read broadly and extends to all economic gains not otherwise exempted. Additionally, treating § 61 to exclude all personal injuries would render the § 104(a)(2) exclusion for personal injuries or physical sickness meaningless. Standnyk v. C.I.R., 367 Fed.Appx. 586 (6th Cir. Ct. App. 2010).
Second, is any of that income obtained through a personal injury settlement or award excludable from taxes?
The Supreme Court has held that a taxpayer must meet two independent requirements before a lawsuit recovery may be excluded under § 104(a)(2). “First, the taxpayer must demonstrate that the underlying cause of action giving rise to the recovery is based upon tort or tort types rights; and second, the taxpayer must show that the damages were received on account of personal injuries or sickness.” Comm’r v. Schleier, 515 U.S. 323, 337 (1995).
In order to satisfy the second prong, the taxpayer must present “concrete evidence demonstrating the precise causal connection” between the taxpayer’s asserted personal injury and the settlement she received. Banks v. Comm’rBanks v. Comm’r,, 345 F.3d 373, 378-79 (6th Cir. 2003). See Sanford v. Comm'r, 95 T.C.M. (CCH) 1618 (2008) (settlement award for emotional distress relating to sexual harassment and discrimination claims is not excludable); Polone v. Comm'r, 86 T.C.M. (CCH) 698 (2003) (settlement award for defamation claim is not excludable), aff'd 505 F.3d 966 (9th Cir.2007); Venable v. Comm'r, 86 T.C.M. (CCH) 254 (2003) (settlement payment for mental anguish and loss of reputation relating to malicious prosecution claim is not excludable), aff'd 110 Fed.Appx. 421 (5th Cir.2004).
In Stadnyk, the court held that the tax court correctly noted that the damages sought by plaintiff against defendant were stated in terms of non-physical personal injuries (i.e., emotional distress, mortification, humiliation, mental anguish, and damage to reputation). Though, being emotional injuries, they are thus not excludable under § 104(a)(2).
In Murphy v. IRS, 493 F.3d 170 (U.S.App.D.C. 2007), the court noted that in 1996 Congress amended § 104(a) narrowing the exclusion amounts received on account of “personal physical injuries or physical sickness” from “personal injuries or sickness,” and explicitly provided that “emotional distress shall not be treated as a physical injury or physical sickness,” thus making clear that an award received on account of emotional distress is not excluded from gross income under § 104(a)(2). The lynchpin is whether a reading of § 61 is to include an award for damages from nonphysical harms.
The court concludes that “for the 1996 amendment of § 104(a) to “make sense,” gross income in § 61(a) must, and we therefore hold it does, include an award for nonphysical damages such as Murphy received, regardless of whether the award is an accession to wealth. The bottom line is that unless there is some direct link between the non-physical damages (pain and suffering, emotional distress, embarrassment and humiliation) and a physical injury that is part of the lawsuit, the non-wage loss proceeds from the settlement or award are not excludable under § 104(a)(2) and are subject to tax.
Another good link on this topic can be found at TaxAnalysts.com.
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